What is Marginal Cost of Funds based Lending Rate (MCLR) reform by the RBI?

The Reserve Bank of India has brought a new methodology of setting lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It has modified the existing base rate system from April 2016 onwards.

As per the new guidelines by the RBI, banks have to prepare Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark lending rates. Based upon this MCLR, interest rate for different types of customers should be fixed in accordance with their riskiness. The base rate will be now determined on the basis of the MCLR calculation.

The MCLR should be revised monthly by considering some new factors including the repo rate and other borrowing rates. Specifically the repo rate and other borrowing rates that were not explicitly considered under the base rate system.

As per the new guidelines, banks have to set five benchmark rates for different tenure or time periods ranging from overnight (one day) rates to one year.

The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting their lending rate. This means that the interest rate given by a bank for deposits and the repo rate (for obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.

Why the MCLR reform?

At present, the banks are slightly slow to change their interest rate in accordance with repo rate change by the RBI. Commercial banks are significantly depending upon the RBI’s LAF repo to get short term funds. But they are reluctant to change their individual lending rates and deposit rates with periodic changes in repo rate.

Whenever the RBI is changing the repo rate, it was verbally compelling banks to make changes in their lending rate. The purpose of changing the repo is realized only if the banks are changing their individual lending and deposit rates.

Implication on monetary policy

Now, the novel element of the MCLR system is that it facilitates the so called monetary transmission. It is mandatory for banks to consider the repo rate while calculating their MCLR.

The RBI calls the effective passing of repo rate change into interest rate change by the banking system as an important part of monetary transmission. Monetary transmission in complete sense is the way in which a monetary policy signal (like a repo rate cut) is passed into the economy in producing the set objectives.

Take the case of a repo rate reduction by the RBI. It is aimed to reduce overall interest rate in the economy and thus promoting loans for consumption and investment. This consumption and investment boost will be realized only if banks are cutting interest rate in response to the reduced repo rate.

Previously under the base rate system, banks were changing the base rate, only occasionally. They waited for long time or waited for large repo cuts to bring corresponding reduction in their base rate. Now with MCLR, banks are obliged to readjust interest rate monthly. This means that such quick revision will encourage them to consider the repo rate changes.

How to calculate MCLR

The concept of marginal is important to understand MCLR. In economics sense, marginal means the additional or changed situation. While calculating the lending rate, banks have to consider the changed cost conditions or the marginal cost conditions. For banks, what are the costs for obtaining funds? It is basically the interest rate given to the depositors (often referred as cost for the funds). The MCLR norm describes different components of marginal costs. A novel factor is the inclusion of interest rate given to the RBI for getting short term funds – the repo rate in the calculation of lending rate.

Following are the main components of MCLR.

Marginal cost of funds;

Negative carry on account of CRR;

Operating costs;

Tenor premium.

Negative carry on account of CRR: is the cost that the banks have to incur while keeping reserves with the RBI. The RBI is not giving an interest for CRR held by the banks. The cost of such funds kept idle can be charged from loans given to the people.

Operating cost: is the operating expenses incurred by the banks

Tenor premium: denotes that higher interest can be charged from long term loans

Marginal Cost: The marginal cost that is the novel element of the MCLR. The marginal cost of funds will comprise of Marginal cost of borrowings and return on networth. According to the RBI, the Marginal Cost should be charged on the basis of following factors:

Interest rate given for various types of deposits- savings, current, term deposit, foreign currency deposit

Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing rate

Return on networth – in accordance with capital adequacy norms.

The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of Funds while return on networth will have the balance weightage of 8%.

In essence, the MCLR is determined largely by the marginal cost for funds and especially by the deposit rate and by the repo rate. Any change in repo rate brings changes in marginal cost and hence the MCLR should also be changed.

According to the RBI guideline, actual lending rates will be determined by adding the components of spread to the MCLR. Spread means that banks can charge higher interest rate depending upon the riskiness of the borrower.

Powerful element of the MCLR system form the monetary policy angle is that banks have to revise their marginal cost on a monthly basis. According to the RBI guideline, “Banks will review and publish their MCLR of different maturities every month on a pre-announced date.” Such a monthly revision will compel the banks to consider the change in repo rate change if any made by the RBI during the month.

Regarding the status-quo of base rate, the initial guidelines from the RBI indicate that the Base rate will be replaced by the MCLR. “Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.”

How MCLR is different from base rate?

The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:

Cost for the funds (interest rate given for deposits),

Operating expenses,

Minimum rate of return (profit), and

Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks)

On the other hand, the MCLR is comprised of the following are the main components.

Marginal cost of funds;

Negative carry on account of CRR;

Operating costs;

Tenor premium

It is very clear that the CRR costs and operating expenses are the common factors for both base rate and the MCLR. The factor minimum rate of return is explicitly excluded under MCLR.

But the most important difference is the careful calculation of Marginal costs under MCLR. On the other hand under base rate, the cost is calculated on an average basis by simply averaging the interest rate incurred for deposits. The requirement that MCLR should be revised monthly makes the MCLR very dynamic compared to the base rate.

Under MCLR:

Costs that the bank is incurring to get funds (means deposit) is calculated on a marginal basis

The marginal costs include Repo rate; whereas this was not included under the base rate.

Many other interest rates usually incurred by banks when mobilizing funds also to be carefully considered by banks when calculating the costs.

The MCLR should be revised monthly.

A tenor premium or higher interest rate for long term loans should be included.